I had the honor of sitting next to Jim Rickards throughout the second day of the conference and I thoroughly enjoyed his company.
He is a very nice and extremely smart gentleman (and as I mentioned last week he gets extra bonus points for treating me like a respected fellow investor and not simply “someone’s wife”!).
Jim discussed a topic he is quite passionate about, Currency Wars: The Making of the Next Global Crisis, which is his latest book (and a great read). He spoke about the importance of history and behavioral science to investing, two things that I am passionate about as well, and presented a compelling case for competitive world-wide currency devaluations and resulting inflation.
He had a lot to say, so I’m going to jump right in! Please let me know what you think about all of this in the comments…thanks!
Jim Rickards — Currency Wars
Jim first discussed the role of currencies in the overall economy, likening them to the ocean (and all creatures of the ocean need to worry about the environment of the ocean, from the tiniest fish to the Great White shark!).
Currencies are the ocean in which every type of financial transaction takes place — every financial transaction is denominated in some currency.
Usually the ocean is calm (periods of stability and low volatility), but sometimes the environment becomes much more hostile and difficult to navigate, and unfortunately we are in one of those periods right now.
What is a currency war?
An effort by one country to improve its economy by devaluing its currency in effect to steal growth from its trading partners.
Jim likened global trading to a small town with four stores who all sell more or less the same products…if one store has a half-off sale, everyone will visit the store with the sale, and with global trading it’s the same process.
For example, several countries manufacture and produce aircraft (the U.S. has Boeing, France has Airbus, etc.).
If we cheapen our dollar and lower the exchange value of the dollar, our U.S. Boeing planes appear to be “on sale” versus other countries’ planes, so countries who are out “shopping” for aircraft (perhaps Thailand, or Indonesia, where they do not produce aircraft) will look favorably on our U.S. Boeing planes.
(And of course you can apply this to everything, whether it’s Microsoft software or Hollywood films or iPads or books or vacations.)
So, it seems quite simple…we can just cheapen our currency, which will help us to sell more aircraft, add to our net exports, reduce our deficits, improve our GDP, and create jobs! (Sounds terrific!)
When politicians look at this they say, “Wow, this is great! We can expand the economy, create jobs, and reduce unemployment, all by devaluing the dollar…what’s not to like? Let’s go cheapen the currency!”
This does sound good, and is a big temptation for politicians, but there is also a lot “not to like” with cheapening the currency.
In fact, Jim brought up four specific things “not to like”:
- The U.S. does not operate in a vacuum—other countries also fight back and cheapen their currencies, too.
- It’s not limited to just currency—a country can also impose an excise tax on imported goods like Nixon did in 1971, which has the same effect as cheapening your currency, and this can quickly morph into trade wars.
- Can impose capital controls. Jim said to look at Brazil…Brazil was the loser in the currency wars recently because they had the strongest currency (it’s like golf—the lower your score the better) so Brazil has imposed a surtax on short-term deposits to discourage the hot money from coming into Brazil.
- Inflation as a consequence — We must remember that we import more than we export. So, if we are cheapening our currency, we are increasing the cost of those imports and are paying more for everything we buy which leads to inflation (which is exactly what the Federal Reserve wants).
Currency devaluation may therefore sound good superficially, but it is not.
Jim said that there is “no greater currency manipulator in the world than the U.S.” (although China wants to manipulate its currency too), and that there is no difference between Obama and Romney on this issue.
Jim loves mathematical models and uses them in his analysis, but cautioned us to be very humble about models because while there are certain things they can tell us, they cannot tell us everything and it is impossible to get every parameter and control “perfect” in your assumptions.
Therefore, he believes strongly in supplementing models with history and behavioral science, something yours truly greatly believes in, too!
He presented us with a brief history of previous currency wars, specifically two in the past 100 years (and he believes the third has already started now).
Currency War I (1921 – 1936)
You’ll note there is some overlap with the U.S. Great Depression, but Jim said that the 1929 date is very U.S.-centric. England was in a depression in 1925, and Germany completely destroyed its economy in 1921.
So, from a global perspective it’s important to go back to the Weimar hyperinflation of 1921 – 1922.
This was the ultimate currency war—Germany took their currency to zero, and their money literally was just litter by the end of it, confetti that they swept down the sewers.
It wasn’t even money anymore.
How did Germany get to that awful state?
Well, after WWI, Germany had reparations imposed on them by England, France, Belgium, and other countries. Germany was told, “look, you started WWI, you lost WWI, and now you’re going to pay for it.” Literally.
So Germany had to pay various reparations to the winning countries, including veteran’s benefits, survivor’s benefits, reconstruction of physical infrastructure that they destroyed, etc.
Apparently they made an effort, but it was just too impossible for them to pay and they couldn’t get out from under all of their debts to the winning countries.
And Jim said it wasn’t just Germany…France and England also owed money, to the U.S, because they had borrowed money to fight the war.
So, everyone was in debt to everyone else, and there was a terrible sovereign debt crisis (sound familiar?).
Jim pointed out that too much debt clogs balance sheets, restricts world trade, and is a major suppressant to economic growth because neither the banks nor the sovereigns have enough capital to stimulate world trade and provide finance for expansion.
The world back then looked a lot like the world today.
So what did Germany do? They fired the first shot in the currency war by hyper-inflating their currency.
Jim said that we all know who the losers were… the middle class was completely wiped out. If you were a teacher, fireman, retiree, or mid-level bureaucrat, then your savings were wiped out and your insurance policies, annuities, and retirement were all worthless.
That is fairly common (yet sad) knowledge, but Jim pointed out that there were a lot of winners, too.
For example, if you owned a factory, you still had a factory and it didn’t matter what the currency was; it was still a valuable producing asset.
Or, if you were a German multi-national and had earnings coming in from strong currencies overseas, you did well, and many people got their money out of Germany and into Switzerland, and others bought gold.
Many people with debts saw their debts devalued, making them easier to pay with cheaper currency.
So there were a set of “losers”, but the winners did very well, and in many cases bought up their competitors for pennies on the dollar (Jim even mentioned one story where people sold things like pianos and furniture to buy just a few day’s worth of groceries!).
What happened next was even more interesting…
To get out of their hyperinflation, Germany went back to a gold-backed currency in 1923.
They had no choice…they had some gold and their goods were so cheap they had a trade surplus (because everyone was enjoying buying German goods “on sale”) and from 1924 – 1929, Germany had the fastest growing major economy in the world.
Then, in 1925 it was France and Belgium’s turn…they wanted to go back to the gold standard, too.
The world had been on the classical gold standard from 1870 – 1914, but it was suspended at the beginning of WWI because countries knew they needed to print money to fight the war.
By the mid-1920’s, there was a strong desire to go back to gold standard. The only question was…at what price?
France and Belgium had printed so much money to fight WWI that gold priced in francs would need to be a lot higher—it would take a lot more French and Belgium francs to purchase one ounce of gold.
So France severely devalued the price of the French franc as compared to gold (or increased the price of gold, depending on how you want to look at it), and went back on the gold standard with a significantly devalued exchange rate for the French franc.
Belgium did the same, but England took a different path. Winston Churchill felt honor-bound to go back to the pre-WWI price, believing that if you were holding the currency (pound sterling) you were a creditor of the Bank of England and therefore by extension of the UK, so he felt duty-bound to go back to the pre-war price of $20.67 / oz.
Jim said to think of it this way: You begin with a parity between gold and sterling, then you double the money supply (to go to war), then you want to go back to parity with gold but you have doubled your money supply, so you have two choices:
- You can increase the price of gold (like France and Belgium, devalue your currency against gold), or
- You can cut your money supply in half
Churchill decided to cut the money supply in half to get back to the old parity, but this threw England into a severe depression and was highly deflationary.
Churchill later said in his memoirs that it was the greatest blunder of his life. (Ouch)
Jim said that to this day he debates mainstream economists about the gold-exchange standard, because they ask him “well, don’t you know that gold caused the Great Depression?”
And Jim says, “Well of course I know that! But it wasn’t gold that caused it; it was the price—they got the price of gold wrong. If they had gone back to gold at $40 or $50 per ounce, which would have been an honest reflection of the paper money that had been printed during WWI, that would have been not only stable but perhaps mildly inflationary and we might have avoided the depression.”
By 1931 it was too much to bear for England. England had to break with gold and suffered a banking panic where people demanded their gold (a run on the banks). England then went off of the gold standard in 1931 and drastically devalued their currency, which did help their economy and gave them some breathing room.
But now, who was the last man standing? Germany, France, Belgium, the UK, all had their chance…but the U.S. was still operating with gold at the old rate.
And this was the most severe period of the Great Depression for the U.S.
The economy and times were exceedingly bad, deflation was overwhelming, and unemployment reached over 20%.
So FDR, on his first day in office in 1933, did two things:
- First, he closed every bank in the country. (Can you imagine? “My fellow Americans, we have decided to close every bank in the U.S. and we will let you know when they re-open…” Banks finally reopened about 10 days later according to Jim.)
- Second, he confiscated all of the gold from all American citizens. And American citizens went along with it!
In fact, Jim said that Fort Knox was built in 1937 to house the gold that had been confiscated from the American citizens.
Jim qualified the word “confiscated”…apparently you did get $20 / ounce in paper money for turning in your gold, but Roosevelt knew he was going to increase the dollar price of gold. FDR wanted the dollar price of gold to go up because it was inflationary and he was fighting deflation. He wanted inflation, like France and Belgium.
Jim relayed a funny story about FDR being in his pajamas in the White House and calling down to his Secretary of the Treasury, “Henry, what do we want the price of gold to be today? I know, let’s bid it up by $.21 because that’s 3 * 7 and 7 is my lucky number!”
So apparently he sent the Secretary of the Treasury to New York and had him bid up the price of gold by $0.21, and over a 6 – 8 month period they got it up to $35 / ounce, where FDR finally locked it down (a 75% increase!).
Jim pointed out that during the greatest period of deflation in American history…gold went up 75% (which is why it does well in times of deflation as well as inflation).
Jim said to think about what this was doing to England, though, because we were now devaluing the dollar which devalued against the pound sterling, too.
Sure enough, by 1936, England and France devalued their currencies yet again, until finally this currency war ended.
Here is a quick run-down of the competitive devaluations:
- 1921 Germany
- 1925 France and Belgium
- 1931 England
- 1933 US
- 1936 England and France
What did we get from these successive devaluations?
One of the worst periods of growth in global history, with massive unemployment, contraction in trade, contraction in industrial production, and deflation of a very destructive kind…in other words, disaster.
Currency War II (1967 – 1987)
Jim pointed out that he intentionally skipped over the Bretton-Woods period from 1944 – 1971 because that was actually a time of currency peace (we were on a form of the gold standard at that time…really a “dollar standard” but we were indirectly linked to gold).
This worked very well through the ‘50s and ‘60’s, but by the late 60’s it came apart.
In 1965, Lyndon Johnson was our newly elected president, and in his January State of the Union address he made two significant announcements:
1. He announced the great expansion of U.S. military presence in Vietnam…he began sending tens of thousands and then hundreds of thousands of troops to Vietnam.
2. He announced “The Great Society”…his welfare and entitlement programs.
This was the famous “Guns and Butter”…guns were the Vietnam War, and butter was the Great Society. Johnson thought we were a rich country and could afford both (but we couldn’t).
So, this was also the beginning of the twin deficits: the trade deficit and budget deficit that have been haunting us ever since.
And this created all kinds of problems…in those days, under Bretton-Woods, if you ran a trade surplus with the U.S. and accumulated a bunch of dollars, you could take your dollars to the Treasury and exchange them for gold.
And many did!
According to Jim, in 1950 the U.S. had 20,000 tons of gold, but by 1970 the U.S. had only 9,000 tons of gold.
Where did the gold go?
- 3,000 tons to Germany
- 2,000 to France
- 2,000 to Italy
- 600 to Netherlands
- Little bit to Japan
And they still have it! They are global powers by today’s standards.
By 1971 (still before yours truly was born) there was a run on the bank, and inflation was the only way out of our debts.
We all know what happened next… Nixon closed the gold window internationally in 1971 (Roosevelt had closed it domestically in 1933).
And ever since that fateful date, the world has been on the dollar standard, not any form of gold standard.
Jim brought up another interesting anecdote of a U.S. government mid-level aid named Pete Peterson who in 1971 wrote a report saying Nixon’s policy would devalue the dollar, increase U.S. exports, and create 500,000 jobs over the next 2 years. (Wow, nirvana!)
And does that sound familiar…? It’s much like what we’re hearing today…
But on the contrary, the U.S. entered its worst period of economic growth other than the Great Depression.
We had three back-to-back-to-back recessions, in 1974, 1979, and 1980, the price of oil quadrupled, unemployment skyrocketed, the stock market crashed, inflation took off between 1977 and 1981, the value of the dollar was cut in half, and there was 50% cumulative inflation in those 5 years.
This would have led to a greater catastrophe, but in 1980 and 1981 we were saved by Paul Volcker (that era’s Ben Bernanke, except an anti-printing-press version) and Ronald Reagan, who created the policy of “King Dollar”.
Using this “King Dollar” policy of a combination of high interest rates and low taxes (the exact opposite of what we have today), they were able to get by without a gold standard because the world accepted that (our fiscal responsibility…hard to even put those two words together in the same sentence today though!).
So, world trade grew, reserve balances grew, countries accumulated dollars (particularly after the 1998 Asian financial crisis as precautionary balances), and countries accepted and trusted dollars.
According to Jim, they had good reason to at the time, because for 20 years, from ~1980 – 2000, we actually maintained a fairly stable and strong dollar under Reagan, Bush, and Clinton.
But now we are entering…
Currency War III (2010 – ?)
And the combatants are the U.S., China, and the euro as a whole.
The world once again, for the third time in 100 years, has decided to expand growth by cheapening its currencies, one against the other.
We now have two cases (previous currency wars) that we can examine in the past 100 years: the 1930’s deflation and the 1980’s inflation. Either case is a possibility, although Jim definitely leans towards inflation, but you need investments that can do well in either state.
Jim says that one of these investments is gold (and I agree). He said that most people “get” that gold does well in inflation, but that gold does very well in deflation, too.
Deflation is a Central Banker’s worst nightmare and something they will avoid at any cost.
So, if you have already cut interest rates to zero and have cheapened the dollar and have done everything you can do but are still facing deflation…you can devalue your currency against gold — it is the inflationary numerator of last resort.
Wrap Up – Economics Lesson
Jim wrapped up his talk by giving us a quick economics lesson and update on where we stand.
(Don’t let the formulas scare you…he explained everything in English, too!) 🙂
GDP = C + I + G + (X – M)
GDP = Consumption + Investment + Government Spending + (Net Exports)
Basically, that’s how economists “compute” our GDP. And here’s what that means and where we are in English…
This is “OK” (I’m sure that’s a technical economic term). 🙂 Seriously, this was reported recently as OK, but in fact it is flat and very sluggish. Consumer debt is awful…think mortgage debt, upside down mortgages, student loans, credit card debt, auto loans, etc.
The consumer is so heavily indebted and burdened that if people do in fact get more income, we are more likely to save it and pay down our debts than we are to spend it as we have been doing for the past 40 years.
This is very weak, and went down in the most recent report. This makes sense… are you going to invest in new equipment if you think the consumer is not going to buy your goods? Possibly if you think the consumer is going to come back next year, but that’s not a likely prospect.
And Jim said that companies are investing in India, and other countries, but that doesn’t count for our GDP.
This is what got us through 2009 and 2010, but between the debt ceiling fiasco and the general sense that there is actually a limit to how much debt-to-GDP we can take on, this has hit a wall.
This is all that’s left…so how do we increase these?
Well, the only way is to cheapen our currency.
The President announced in his State of the Union address in January 2010, a new “National Export Initiative”, saying, “It is the policy of the U.S. to double exports in 5 years”.
(Kung Fu Girl Note: cough…double???)
But how are we going to do this?
Jim was really funny here, saying “we’re not going to be twice as productive, we’re not going to get twice as smart, there’s not going to be twice as many of us…”
So really, the only way we can do this is to cheapen our currency, and this is exactly the policy of the Fed and the Treasury and the White House.
He illustrated this with some “basic quantitative theory”:
1 + 4 = 5
4 + 1 = 5
(My kind of math!) 🙂
The first term is inflation and the second term is real growth.
So the first little equation is terrific, with 1% inflation and 4% real growth…5% growth is really exceptional growth for the U.S., and according to Jim is Central Bank nirvana. (He really is hilarious, and I encourage you to listen to him speak live sometime!)
The second equation however, means 1% real growth and 4% inflation.
Now both of these get to the same end goal of “5”, and Jim says that of course the Fed prefers the first one, but they will take the second one…they just need the “5”. If the Fed can’t get real growth, they’ll take inflationary growth.
Just one more reason to be concerned about inflation.
Money Supply Chart
He also showed us a chart of the money supply and said to expect QE3…but everyone is wondering “where is all this inflation” if we have increased the money supply so dramatically?
The Fed can print all of the money they want (and they are…) but it is up to us to spend it (and banks to lend it). Right now the velocity of money is declining, which the Fed cannot control (they can’t control that except by manipulating our behavior, which is why they are so secretive!).
Bernanke has said in press conferences that inflation of 2% is wishful thinking and it will go beyond that.
But they need a shock factor, because if they target 2% and deliver 2% the behavior impact is zero.
But, if they promise 2% and then deliver 4%, some people might be shocked into action—“I’d better go lock in that mortgage before rates go up! I’d better go buy that car!”, etc.
He took a few more great questions on SDR’s and more, but I think that’s enough for today! I highly encourage you to pick up Jim’s book if you haven’t read it yet, and to get yourself to a live conference soon! I believe the next Casey one is in September of this year.
Have a fantastic week, and let me know what you’re doing to prepare for the next currency war!
Who do you think will win?
To your financial success,
—Kung Fu Girl